Tuesday, December 16, 2008

Spreads continue to tighten across the board, and today's FOMC announcement only accelerated the process. 2-year swap spreads, shown here in red, have improved dramatically since their peak in early October. They are still unusually wide, but at this rate are well on their way to returning to more normal levels. This is a clear sign that the inner workings of the fixed-income market are healing. Confidence is returning, fear is subsiding, and liquidity is improving.

The fixed-income market is telling the equity folks, "hey, come on in, the water's not that cold!" But the equity market is still in a once-burned-twice-shy mode.

3 comments:

Love the blog.What is your take on TIPs rallying today and the 30 year Treasury bond also moving up? You would think with deflation concerns diminishing, we would see yields move up on the 30 year soon.

Are people still afraid to sell the long end because of fear over just many long term treasury securities the Fed might buy?

Some of it might be inflows into Treasury funds as people chase this year's top performing funds.

The decline in Treasury yields was mostly a reaction to the Fed's pledge to buy bonds and drive longer maturity rates lower. The market is front-running the Fed, buying bonds before the Fed buys them. I think this is a nutty idea, since aggressive monetary policy has a high risk of generating unwanted inflation and in turn higher interest rates.

The decline in TIPS yields was driven by the decline in Treasury yields; it's very common for both markets to move in the same direction.

Most interesting, however, was the fact that TIPS yields fell much more than Treasury yields today. That means that inflation expectations rose (or you might say inflation expectations became less negative).

That all yields fell means the market is still obsessed by the prospects for deflation. But with TIPS yields falling more, the market is telling us that deflation risk is declining.

So we're still in a deflation rut, only it's less likely we'll be stuck in it for as long as the market had feared.

Maybe we'll see more of this action, but eventually we'll come out of the deflation rut completely, and at that point TIPS yields will continue to fall (as demand for inflation hedges rises) but Treasury yields will rise. That would signal the rebirth of inflation fears, whereas now we're seeing the decline of deflation fears.